(Trusts and Estates) Introduction to the Revocable Trust
A revocable trust is simply a trust that can be revoked by the settlor. A settlor who creates a revocable trust typically retains the power to revoke the trust during his or her lifetime.
All revocable trusts are ”living” trusts; that is, trusts that are created and become operational during the lifetime of the settlor. Since a settlor can revoke a trust only while the settlor is living, a revocable trust may be created only during the settlor’s lifetime. In contrast, trusts created by will are known as ”testamentary trusts” and are always irrevocable. Most revocable trusts become irrevocable at some point during their existence. Typically, this will occur on the settlor’s death. When a trust is created by joint settlors, a portion of the trust usually becomes irrevocable on the first settlor’s death, with the balance typically remaining revocable during the lifetime of the surviving settlor.
Types of Revocable Trusts
There are many types of revocable trusts, and these trusts are often categorized according to their purpose, or according to the general pattern of distribution specified in the trust instrument. Some of the more commonly encountered terms used to describe specific characteristics of revocable (as well as testamentary) trusts are:
(1) ”Pot” (or ”family pot”) trust, which describes a single trust fund or share with multiple beneficiaries (who, in the case of a ”family pot” trust, are members of the same family; typically the children and grandchildren of the settlor).
(2) ”Separate share” trust, which describes a trust set up for the benefit of only one income beneficiary; typically a child or grandchild of the settlor under an arrangement whereby a single trust instrument creates separate trusts for each beneficiary.
(3) ”Sprinkling” trust, which describes a trust that gives the trustee discretion to allocate trust income and/or principal among the various trust beneficiaries in accordance with criteria specified in the trust instrument.
(4) ”Marital deduction” trust, which describes a trust designed to avoid federal estate tax on the death of the settlor by naming the settlor’s spouse as life beneficiary of the trust in a manner that will qualify for the federal estate tax marital deduction. Marital deduction trusts are further subdivided into ”lifetime income/power of appointment” trusts, ”qualified terminable interest property” (or ”QTIP”) trusts, ”qualified domestic trusts” (or ”QDOTs”), and ”estate trusts.”
(5) ”Bypass” or ”credit shelter” trust, which describes a trust that is designed to avoid taxation in the estates of both the settlor and the settlor’s surviving spouse by taking advantage of the unified credit against federal estate and gift taxes. Bypass trusts typically are used in conjunction with marital deduction trusts.
(6) ”Spendthrift” trust, which describes a trust designed to protect the trust assets from the creditors or prospective creditors of the beneficiary.
A given trust may possess a combination of the characteristics discussed above. Thus, for example, a bypass trust may also be a ”sprinkling” trust as well as a ”spendthrift” trust. Moreover, it is common for trust instruments to establish more than one individual trust, or to provide for division or (less frequently) combination of trusts at various points during the duration of the estate plan contemplated by the trust instrument.
In California, revocable trusts are commonly created for the purpose of avoiding probate of the trust assets on the settlor’s death. Because the trustee and not the settlor holds title to the assets, it is not necessary to subject the assets to probate administration when the settlor dies. The trustee continues to hold the assets after the settlor’s death. This continuity of title is not affected by the settlor’s death. If the settlor was the original trustee, a successor trustee (designated in the trust instrument or appointed by the court) will take over the original trustee’s duties when the settlor dies. Settlors commonly serve as trustees of revocable living trusts without impairing the probate avoidance objectives of the trusts.
However, probate will be avoided only to the extent that assets are actually transferred to the trustee while the settlor is living. If an asset is outside the trust when the settlor dies, that asset is not part of the trust and cannot be dealt with by the trustee or successor trustee. Unless the asset can be transferred in some other way (for example, by a judicial ”set aside” or affidavit procedure), the asset will be subject to probate.
Asset Management and Avoidance of Conservatorship
Asset management is the second major reason for creating a revocable trust. A settlor who is unable or unwilling to manage his or her own assets may prefer to transfer that responsibility to someone else. Asset management may be achieved by entering into a management contract with a professional investment adviser or manager, or by creating a trust and transferring the assets that are to be managed to the trustee. The trustee will have the responsibility for collecting income from the assets, paying expenses (including taxes) attributable to the assets, seeing to it that the assets are properly insured and maintained, and, when appropriate, selling the assets and investing the proceeds in other property.
Asset management is ordinarily a concern to two classes of persons: (1) those who are unsuited by training, experience, or natural ability to manage assets that they have acquired by inheritance or gift; and (2) persons who cannot manage their own assets because they are incapacitated, or who are concerned that they may become incapacitated at some later time. For example, spouses and children with little business experience or aptitude sometimes inherit substantial estates that they are ill-prepared to manage. Realizing their limitations, they may elect to transfer the assets to the trustee of a revocable trust so that the trustee will manage the assets. If the assets are valuable, they may select a trustee with professional property management experience (for example, a bank, trust company, or individual professional private fiduciary).
A person who has acquired a substantial estate through his or her own efforts may have no difficulty in managing the assets now, but may anticipate that he or she may lose interest or have difficulties in the future. Such a person may create a revocable trust, name himself or herself as the original trustee, designate another person (or bank) as the successor trustee, and authorize the successor trustee to take over the trust if and when the settlor no longer wants to manage the trust assets or becomes incapacitated. This will help to avoid the necessity for seeking the appointment of a conservator if the settlor ever becomes incapacitated. Conservatorships, like probate proceedings, are highly regulated and typically involve expensive and time-consuming judicial proceedings. A revocable trust (particularly when executed in conjunction with a durable power of attorney for property management) may avoid the need for a conservatorship.
The revocable trust is well suited to preserving the settlor’s privacy, both during the settlor’s lifetime and after the settlor’s death. If assets are held in the name of the trustee, it may be possible to conceal the settlor’s true identity as the owner of the trust assets. Third parties, such as brokers, transfer agents, and title insurers, may ask to examine the trust instrument (which will, of course, disclose the identity of the settlor), but the instrument itself is not a public document. It need not be recorded, and it can be shielded from unwanted public examination (except in the rare case when litigation concerning the affairs of the trust becomes necessary).
Clients sometimes are under the impression that revocable trusts may be used as tax-savings devices. As a general proposition, this is not true. Revocable trusts are often described as ”tax-neutral”–that is, as a general rule they neither increase nor decrease overall income or estate tax liability. Because the settlor retains the power to revoke a revocable trust, no irrevocable transfer of the trust assets takes place until the settlor dies, and the settlor’s assets therefore are included in the settlor’s estate for federal estate tax purposes. Similarly, the income of a revocable trust is taxed to the settlor for federal income tax purposes.
Choosing Between Revocable Living Trust and Irrevocable Trust
Revocable living trusts differ from irrevocable trusts in one obvious key respect: revocability. Although this difference in itself is relatively simple to understand, the consequences that flow from the difference have enormous importance.
Since the right to revoke a trust is an important and valuable right, a settlor will usually give up that right only in return for some advantage. Typically, this advantage will be a tax advantage. As discussed above, a revocable living trust is not treated as a separate entity for tax purposes. In contrast, irrevocable trusts that meet applicable tax requirements are treated as separate entities for federal income and estate tax purposes. Income generated by the trust is taxed to the trust itself, or to the trust beneficiaries, rather than to the settlor, and trust assets will not be subject to estate taxation in the settlor’s estate when the settlor dies.
Creation of an irrevocable trust, or transfer to an existing irrevocable trust, may generate gift tax liability to the settlor or donor at the time of transfer. However, any subsequent appreciation in the trust assets ordinarily is removed from the settlor’s estate, and thereby may escape some or all of the estate and income tax to which it otherwise would be subject.
The essential difference between the uses of revocable living trusts versus irrevocable trusts in estate planning may be better understood if the irrevocable trust is thought of as a gift substitute and the revocable living trust is thought of as a probate substitute. An irrevocable trust is used to give property away during the settlor’s lifetime, while a revocable living trust is used to retain the property during the settlor’s lifetime and pass it to designated beneficiaries without probate after the settlor’s death.